What Is a Mortgage Backed Security?
A Mortgage Backed Security (MBS) is a type of debt obligations that represents a claim on the cash flows generated by a pool of mortgage loans. These securities are a core component of the fixed income securities market, falling under the broader category of structured finance. Essentially, a mortgage backed security is created when a bank or other financial institution sells a group of mortgage loans to a government-sponsored enterprise (GSE) or another financial entity. This entity then pools thousands of these individual loans together and issues securities to investors, who receive regular payments derived from the principal and interest payments made by the homeowners. This process, known as securitization, allows lenders to free up capital to originate new mortgages, while providing investors with a way to invest in the housing market without directly owning individual mortgages. A mortgage backed security can be bought and sold on the secondary market.
History and Origin
The concept of pooling mortgages and selling them to investors gained traction in the United States to address inefficiencies in the housing finance system. Historically, banks retained mortgages on their books, which limited their capacity to issue new loans. The creation of the first mortgage backed security in 1970 by the Government National Mortgage Association (Ginnie Mae) was a pivotal moment. Ginnie Mae developed this security to allow many loans to be pooled and used as collateral in a security that could be sold in the secondary market. This innovation aimed to provide greater liquidity to the mortgage market and channel investment capital into housing. Ginnie Mae’s development of the first MBS in 1970 revolutionized mortgage finance by enabling the securitization of pooled loans, thereby increasing the availability of funds for new mortgages.
4The market for mortgage backed securities expanded significantly in the decades that followed, with the emergence of other government-sponsored enterprises like Fannie Mae and Freddie Mac. While Ginnie Mae guarantees securities backed by government-insured or guaranteed loans (such as FHA or VA loans), Fannie Mae and Freddie Mac purchase and securitize conventional mortgages. The growth of the MBS market, particularly those backed by subprime mortgages, played a significant role in the 2008 financial crisis. The Federal Reserve and the U.S. Treasury took significant actions during the crisis, including purchasing large quantities of agency mortgage backed securities, to support financial markets and reduce longer-term interest rates.
3## Key Takeaways
- A Mortgage Backed Security (MBS) is an investment vehicle composed of a pool of mortgage loans.
- Investors in an MBS receive payments derived from the principal and interest paid by homeowners on the underlying mortgages.
- MBSs facilitate the flow of capital to the housing market by allowing lenders to sell off loans and originate new ones.
- Government-sponsored entities like Ginnie Mae, Fannie Mae, and Freddie Mac play a central role in the MBS market.
- Like other fixed income investments, MBSs carry risks such as prepayment risk and interest rate risk.
Interpreting the Mortgage Backed Security
Interpreting a mortgage backed security involves understanding its unique characteristics and the factors that influence its performance. Unlike traditional corporate bonds, the cash flows from an MBS are not fixed and can vary due to borrower behavior. The primary factor is the prepayment risk, which refers to the possibility that homeowners will pay off their mortgages earlier than expected, often by refinancing when interest rates fall or by selling their homes. This means investors may receive their principal back sooner than anticipated, potentially at a time when reinvestment opportunities offer lower yields.
Conversely, when interest rates rise, homeowners are less likely to refinance, which can extend the average life of the MBS and expose investors to interest rate risk for a longer period. Investors assess an MBS by looking at its underlying mortgage pool's characteristics, such as credit scores of borrowers, loan-to-value ratios, geographic distribution, and average loan age. The expected yield of an MBS is heavily influenced by these factors and projections of future interest rates and prepayment speeds.
Hypothetical Example
Imagine a bank has originated 1,000 individual residential mortgages, each with an original principal balance of $200,000, a 30-year term, and an average interest rate of 4.5%. Instead of holding all these loans on its balance sheet, the bank decides to sell them to a government-sponsored enterprise (GSE). The GSE pools these 1,000 mortgages, creating a pool with an aggregate principal balance of $200 million.
The GSE then issues a mortgage backed security representing claims on the cash flows from this $200 million pool. An investor, such as a pension fund, decides to purchase $1 million worth of this mortgage backed security. As the 1,000 homeowners make their monthly principal and interest payments, these payments are collected by a servicer and then passed through to the MBS investors. If some homeowners prepay their mortgages (e.g., by selling their homes or refinancing at a lower rate), the investor will receive a larger portion of principal back sooner than initially projected. Conversely, if homeowners pay slowly, the bond's duration may extend. The pension fund, as a bondholder, receives its pro-rata share of these aggregated payments, effectively earning a return on its investment without directly managing thousands of individual mortgage loans.
Practical Applications
Mortgage backed securities are widely used in global financial markets and have several practical applications:
- Investment Portfolios: Institutional investors, such as pension funds, insurance companies, and mutual funds, frequently include MBSs in their portfolios as a source of steady income and diversification within fixed income investing. Their generally high credit quality, particularly those guaranteed by government entities, makes them attractive for conservative investors.
- Monetary Policy: Central banks, including the U.S. Federal Reserve, utilize MBSs as a tool for implementing monetary policy. During the 2008 financial crisis and subsequent periods, the Federal Reserve engaged in large-scale purchases of mortgage backed securities to lower long-term interest rates and stimulate the housing market and broader economy. The Federal Reserve's purchases of agency mortgage-backed securities helped reduce mortgage rates and support the flow of credit.
*2 Capital Management for Banks: For mortgage originators, securitizing loans into MBSs allows them to remove these assets from their balance sheets. This frees up capital that can then be used to originate new loans, thereby increasing lending capacity and generating new revenue streams through origination and servicing fees. - Benchmarking and Derivatives: The MBS market provides benchmarks for mortgage rates and serves as an underlying asset for various derivative products, such as MBS futures and options, used for hedging and speculation.
Limitations and Criticisms
Despite their role in facilitating mortgage finance, mortgage backed securities have faced significant limitations and criticisms, particularly highlighted by the 2008 financial crisis.
- Prepayment Risk: As discussed, the unpredictable nature of homeowner prepayments makes MBS cash flows less certain than traditional bonds. When interest rates fall, homeowners refinance, and investors get their principal back, often having to reinvest at lower prevailing rates, which is known as "call risk" or negative convexity.
- Credit Risk (for non-agency MBS): While agency MBS (those issued by Ginnie Mae, Fannie Mae, and Freddie Mac) carry a government or implied government guarantee, non-agency MBS are exposed to the full credit risk of the underlying borrowers. During the housing downturn leading up to 2008, significant defaults on subprime mortgages within non-agency MBS pools led to massive losses for investors.
- Complexity and Opacity: Especially for more complex MBS structures like collateralized mortgage obligations (CMOs), the intricacy of how payments are distributed among different tranches can make them difficult to understand and value. This complexity contributed to mispricing and a lack of transparency in the run-up to the financial crisis.
- Systemic Risk: The widespread adoption and interconnectedness of MBSs within the financial system mean that problems in the housing market can quickly spread and pose systemic risks, as demonstrated in 2008. The U.S. Securities and Exchange Commission (SEC) provides investor alerts regarding the risks associated with investing in mortgage backed securities and collateralized mortgage obligations.
1## Mortgage Backed Security vs. Collateralized Mortgage Obligation
While often discussed together, a Mortgage Backed Security (MBS) and a Collateralized Mortgage Obligation (CMO) are distinct, though related, concepts. An MBS is the foundational security created directly from a pool of mortgages, where investors receive a pro-rata share of the aggregated principal and interest payments. The cash flows from a simple "pass-through" MBS are directly tied to the performance of the underlying mortgage pool, meaning all investors face the same prepayment risk.
A CMO, on the other hand, is a more complex type of asset-backed securities that is often created from a pool of existing MBSs. CMOs divide the mortgage cash flows into different debt classes, or tranches, each with different maturities, payment priorities, and risk profiles. This structuring aims to redistribute prepayment risk and interest rate risk among investors, allowing them to choose a tranche that better suits their risk tolerance and investment objectives. For instance, some tranches might be designed to have shorter average lives and lower prepayment risk, while others absorb more of this risk in exchange for potentially higher yields.
FAQs
What is the main difference between an agency MBS and a non-agency MBS?
The main difference lies in the guarantee. An agency MBS is issued by a government-sponsored enterprise (GSE) like Ginnie Mae, Fannie Mae, or Freddie Mac, and often carries an explicit or implicit guarantee of timely principal and interest payments. This guarantee significantly reduces the credit risk for investors. A non-agency MBS, in contrast, is issued by private entities and does not have such a guarantee, making investors fully exposed to the credit risk of the underlying mortgages.
How does changing interest rates affect a mortgage backed security?
When interest rates fall, homeowners are more likely to refinance their mortgages, leading to faster prepayments within the MBS pool. This results in investors receiving their principal back sooner, often having to reinvest at lower prevailing rates, which can reduce the overall yield of the MBS. Conversely, when interest rates rise, prepayments tend to slow down, extending the average life of the MBS and potentially making it less attractive if newer bonds offer higher rates.
Are Mortgage Backed Securities safe investments?
The safety of a mortgage backed security depends largely on its issuer and the quality of the underlying mortgages. Agency MBSs, backed by the U.S. government (Ginnie Mae) or implicitly by the government (Fannie Mae, Freddie Mac), are considered very safe due to their low credit risk. Non-agency MBSs carry higher credit risk, as they depend entirely on the creditworthiness of the borrowers in the pooled mortgages and the structuring of the security. All MBSs, however, carry prepayment risk.